Broadcom founder allegedly shown taking illegal drugs on YouTube

Here’s a no-win situation for an attorney: What do you do when a your client, the founder and former CEO of a billion-dollar public company, is supposedly being shown on YouTube using illegal drugs?

According to a motion filed by federal prosecutors on Thursday, the quandary arose last summer when such videos were posted of Henry T. Nicholas, III, the co-founder and former CEO of Broadcom (BRCM), the high-profile, fabless semiconductor company based in Irvine, California.

(Last Thursday Nicholas pleaded not guilty to two federal indictments, one charging options backdating and the other conspiracy to distribute drugs, including MDMA (ecstacy), methamphetamine, and cocaine.)

In August 2007 Nicholas attorney Susan Szabo of Munger Tolles & Olson wrote e-mails and faxes to YouTube and parent Google (GOOG) demanding they take down a video of Nicholas, which, she said, invaded his privacy.

A YouTube support rep e-mailed Szabo back explaining that the company couldn’t process a privacy complaint “based on what a video ‘purports’ to portray,” so he invited her to confirm that the video really did show her client in a private setting without his consent.

Szabo complied: “I can confirm that the video portrays my client and that the video was taken surreptitiously in his bedroom, without his knowledge and consent, and that any distribution of the video is without his consent.”

Now, in a motion asking that Nicholas be detained pending his trial on the two indictments, the government cites the video – which, it claims, shows Nicholas using drugs at a time when he knew the government was investigating him and when he was publicly denying drug use to the media – as tending to show that Nicholas presents a risk to the community and a flight risk. Prosecutors write: “There can be no doubt it was defendant in the video as his attorneys sent an e-mail and letter to YouTube confirming that the person in the video using drugs is, in fact, defendant.” (The judge ultimately ordered certain “home detention” measures for Nicholas.)

An e-mail to attorney Szabo was not immediately returned. Nicholas’s criminal defense attorney, Brendan Sullivan, wrote: “I adhere to a policy that I should not discuss matters in litigation.”

The government’s 18-page detention motion, with 100 pages of appended exhibits, also levels a variety of other unflattering accusations beyond those already contained in the indictments. During a June 2007 flight on one of his private jets, for instance, Nicholas allegedly accused a “longtime friend, personal attorney, and employee” of wearing a “wire”; threatened to “chase him to the ends of the earth” if the friend “screwed” him; and then struck the friend in the face, causing him to fall to the ground.

The papers also allege that in November 2007 Nicholas, while driving with his son, crashed his black Lamborghini into a lamp post while returning from a Shake Shack. He switched cars with a security staffer in his convoy and then left the scene while the staffer waited for the police and took the rap. Through an attorney, Nicholas later admitted to local police that he’d been driving the Lamborghini, but claimed that the security staffer had suggested Nicholas drive home for “security reasons,” and that Nicholas had never intended that the staffer take responsibility for the crash. (The staffer, according to prosecutors, has refused to testify about the incident notwithstanding an immunity order, and is currently incarcerated on contempt charges.)

Nicholas stepped down as Broadcom’s CEO and co-chairman in 2003, explaining in a statement that he wanted “to attend to serious family matters.”

Brocade witness “recants”; Reyes seeks new trial

On Friday, Brocade’s former CEO Greg Reyes asked for a new trial on the grounds that a prosecution witness at his trial — the only witness the government chose to call from Brocade’s (BRCD) finance department — has allegedly recanted portions of her testimony.

Reyes was convicted last August of ten federal felonies, including securities fraud, in connection with options backdating at the firm. His sentencing date has not yet been set.

Appended to Reyes’s motion are two affidavits from confidants of the witness, Elizabeth Moore, attesting to things Moore has allegedly told them since the trial, as well as a copy of an e-mail Moore sent to one of them. In the email sent October 24 to Reyes’s “house manager” Angela Restrepo-Steger, Moore wrote: “I’ve read the closing argument over and over and I’m angry with [prosecutor Timothy] Crudo twisting around what I said, and bullying me into saying things I didn’t intend to say. I’ve read those dreaded lines I said over and over and I can’t believe it carried as much weight as it did. . . . I want to find a way to fix this, my heart is heavy with guilt and I want to fix this now.” In a third affidavit, a friend of Moore’s who still works at Brocade, Barbara Keller, provides a hearsay account of similar remarks Moore allegedly made to a mutual friend.

I should add that Moore also contacted me in early October, in a comment to Fortune’s Legal Pad, and made similar, distraught statements, which I’ll set out in detail at the end of this post.

In an e-mail Crudo says he will respond to the motion in “due course,” but that he has no comment now. A spokesman for his office, the U.S. Attorney’s Office in San Francisco, also declined comment.

Moore did not testify at the recently completed trial of Reyes’s co-defendant, former human resources chief Stephanie Jensen. (Jensen was convicted of the two less serious offenses with which she was charged.) According to Reyes’s filings, Moore’s attorney, George Niespolo, had informed Crudo in November that if he called to testify at Jensen’s trial, Moore would invoke her Fifth Amendment privilege against self-incrimination.

On November 13 Crudo e-mailed Reyes’s and Jensen’s attorneys, advising them of Niespolo’s message, and stating that Niespolo declined to provide details of why Moore was taking this position “except to add that it was somehow related to her prior testimony.” (Crudo’s e-mail appears intended to carry out his constitutional duty to turn over possible so-called Brady material — i.e., evidence tending to exculpate a defendant.)

Reyes’s attorney, Richard Marmaro, wrote Crudo back on November 16, demanding that Crudo “investigate this issue further to prevent a miscarriage of justice. The truth-seeking function of the trial process ‘cannot be fulfilled when the state, knowing that a witness may have perjured herself, proceeds without conducting an investigation to ensure that a new trial is not warranted’ [case citation omitted].”

In the current motion, Marmaro — noting that he has never heard back from Crudo — seeks a court order forcing Crudo to grant Moore “use immunity” so that she can testify as to what she knows.

Though Reyes’s counsel Marmaro characterizes Moore’s testimony in his motion as having constituted the “heart” of the prosecution’s case, and says Crudo referred to it 25 times in his closing argument, it is not at all clear that Judge Charles Breyer will see it in the same light. The Moore testimony at issue concerns whether, and the degree to which, Brocade’s finance department knew about the options backdating procedures being used by Reyes and Jensen. But in an August 29 order denying an earlier motion for a new trial by Reyes, Breyer wrote: “Of course, notwithstanding the parties’ emphasis on this subject, what the finance and accounting departments did or did not know about the scheme is certainly not determinative of Reyes’ criminal liability.”

In any event, the potential importance of Moore’s “recantation” lies in the prosecution’s having argued at trial, among other things, that Reyes deceived Brocade’s finance department about the existence of options backdating at the company. Moore, who administered options plans, bolstered the government’s argument by testifying that she had not been aware that option grant dates were being selected retroactively. If Reyes kept the scheme secret from the finance people, the argument went, he probably understood that retroactively selecting option grant dates had accounting ramifications and was probably trying to evade those ramifications illegally.

If, on the other hand, everyone in the finance department knew that options grant dates were being selected retroactively and they were voicing no objections to such conduct, then it would be more plausible that Reyes might have mistakenly believed that such a procedure was lawful — i.e., carried no special accounting or disclosure requirements that were not being fulfilled.

According to one of the confidants who submitted an affidavit supporting Reyes’s current motion, Moore said her testimony on this subject at trial had been inaccurate.

“Ms. Moore told me that when the prosecution asked her about the dates on certain documents, she testified that she assumed that the date on the document was the date Mr. Reyes signed it,” writes James Hulbard, a Merrill Lynch official who became friends with Moore when he was at Deutsche Bank Alex Brown, which provided stock and financial services for Brocade employees. “Ms. Moore told me that this testimony was not accurate . . . [and] what she meant to say was that she did not care when Mr. Reyes actually signed the document.”

“Ms. Moore also told me that she was reviewing the trial transcripts of the prosecution’s closing argument and that she was shocked at the prosecution’s characterization of her testimony,” Hulbard continues. “She told me that the prosecution’s characterization of her testimony was making her sick.”

In a subsequent conversation, Hulbard continues, “Ms. Moore said that while Brocade employees did not refer to the practice as backdating, she and others in the finance department at Brocade knew that Brocade looked back and picked favorable prices for employee stock options. . . . Ms. Moore also told me she was angry that Bob Bossi, Brocade’s former controller, had not come forward because he could have set the record straight.”

Hulbard also says that when he asked Moore why she hadn’t testified truthfully at trial, she indicated that she was concerned about being fired from her job at Brocade, and about being blacklisted and having difficulty getting another job. . .. Ms. Moore also told me . . . that she felt pressured and bullied by the prosecution and the Securities and exchange Commission.”

On October 2, Elizabeth Moore wrote a public comment to a piece I’d published about the Brocade case for this blog. The comment included her complete name, telephone number, and e-mail. I called her to see if she really was who she claimed to be and, satisfied that she was, I published it. At 4:34 pm, however, she e-mailed me and said that she hadn’t realized that her phone number and e-mail would be posted, and asked me to remove her comment. I asked if she meant just her contact info or the whole letter, and she wrote back: “Actually, take down the whole letter for now, I want to rewrite it. I have some stuff to add.” As a courtesy, I did take down the comment, but she never sent another.

I copied and saved her comment at the time, however, and will now publish it below (except for her phone and e-mail):

I’m sending you a message regarding the Brocade/Greg Reyes backdating trial. I was one of the first witnesses called, Elizabeth Moore. I was with Brocade from April 2000 through July 2007. I only recently left and joined VMware. I submitted a letter to Judge Breyer looking for leniency for Greg Reyes. I truly believe there has been a serious miscarriage to justice in this case, principally as a result of the prosecution team led by Timothy Crudo. The actual person who developed the stock option program was Mike Byrd. He modeled Brocades stock option program the same as when he was CFO at Maxium [sic]. It’s not fair that Mike Byrd [Brocade’s CFO from 1999 to 2001, and president and COO from 2001-2003] was given immunity when he was the CFO of Brocade for the years in question. I worked with Mike Byrd and I know for a fact he was aware of everything. I have been struggling with this verdict and feel like I need to speak my peace. Below is the letter I submitted to Judge Breyer.

[Shortly after Reyes’s was convicted, the SEC brought a civil complaint against Michael Byrd, alleging that he “knew, or was reckless in not knowing,” that others at Brocade were backdating options. I have a call and e-mail into his attorney, John Potter, seeking comment on Moore’s accusations about Byrd. Potter has previously said that Byrd did not know that options backdating was taking place at Brocade. “A jury unanimously accepted the United States Attorney’s position that Mr. Byrd had no knowledge of these illicit activities,” Potter told Bloomberg News in late August.–RHP]

I worked at Brocade from April 2000 to July 2007 as the Stock Plan Administrator. I met Greg the first week at Brocade because he came by my desk to welcome me and introduce himself. I was very surprised a CEO would even do that but after he introduced himself I knew I was at the right company lead by the right person. I truly enjoyed my 7 years at Brocade, especially the years Greg was the leader.

I have been through almost every step that has lead up to Greg’s trial. I can’t begin to tell you how devastated I am by the verdict. Because I was so closely involved and worked with Greg for many years, I am struggling to make sense of the verdict and what he is possibly facing. Not a day has gone by that I don’t think about Greg and his family, and how his two beautiful children may have their father taken away from them. The Greg I know would have never intentionally done anything wrong.

The most impressive memory I have of Greg, was his reaction to our country’s 9/11 attack. Greg immediately called the company together and made sure all of Brocade’s employees and their families were OK and accounted for. Greg went out of his way to help everyone get home, and to ensure everyone’s family knew their loved one’s were OK. Greg also directed the sales teams to reach out to customers and partners in and around NYC to offer technical assistance, free of charge to help everyone in need. Greg then fully supported the ongoing charitable efforts related to 9/11, encouraging all of us to help as much as we could, and then matching all of the contributions.
I learned over the years of Greg’s commitment to his family through work functions and sporting events. Greg would bring his kids to Brocade from time to time, and it was easy to see how fond and proud he was of them both. His kids and wife are very close to Greg and I know his incarceration will cause them to suffer more than anyone else. I don’t believe Greg’s family nor our society would benefit from his incarceration. For these reasons I ask the court for leniency in Greg’s sentencing.

Judge: Brocade CEO’s crimes caused no loss

Though it must be hard for him to celebrate, Brocade’s (BRCD) former CEO Gregory Reyes — convicted of 10 felonies last August in connection with options backdating at the company — actually got some good news this week.

On Wednesday, shortly after a federal jury convicted his former human resources chief Stephanie Jensen on two felony counts stemming from the same scheme, U.S. District Judge Charles R. Breyer of San Francisco unsealed an order he had already entered on November 27 that will have a major, positive bearing on Reyes’ sentence.

Breyer found that the government had failed to “quantify any amount of loss that can be attributed to Reyes’ conduct.” As a consequence, he calculated Reyes’ recommended sentencing guidelines range to be 15-21 months, almost 20 times lower than the top range proposed by the government: 292-365 months. The ruling ishere.

The government had proposed four alternative methods for estimating the size of the pecuniary loss caused by Reyes’ crimes, but Breyer rejected all of them.

First was a “market cap” approach, in which it toted up the total of number of shares sold on January 7, 2005 — the day after Brocade disclosed that it would need to make a restatement, due to options backdating — times the $0.52 stock drop that occurred that day, as Brocade shares fell from $6.92 to $6.40 in value. That arithmetic produced a $3.2 million figure.

Breyer said that number was inflated as an estimate of loss, though, because so many shares sold that day had probably been purchased at prices much lower than $6.92. (For the two years preceding January 7, 2005, Brocade’s average closing price had been $5.92.)

Next, the government suggested simply using as a measure of loss the amount of the civil fine Brocade paid to the Securities and Exchange Commission — $7 million — or the amount it voluntarily paid to the Internal Revenue Service to cover the tax obligations of the employees who had received the backdated options. But no judge had ever before used those benchmarks for criminal sentencing purposes, and Breyer declined to become the first.

Third, the government suggested an estimate called “rescissory loss.” It computed the average trading price of Brocade shares during the entire four-year span of the scheme — going back to January 26, 2001, when Brocade’s price stood at a stratospheric $108.38 — and then compared that number to Brocade’s average trading price during the five weeks immediately following the announcement of the need for a restatement. Assuming that the reduction in value of nearly every share between those two periods could then be attributed to the backdating scheme, the government calculated a loss of between $2.5 billion and $3 billion. But Judge Breyer found that loss to be “overwhelmingly the result of extraneous factors” — mainly the popping of the tech bubble.

Finally, the government suggested that the court calculate Reyes’s “personal gains” from the scheme, but Judge Breyer found that there weren’t any — at least none that could be proven by clear and convincing evidence.

Though Breyer has now calculated Reyes’s recommended guideline range, he still has some discretion to vary upward or downward from it. He has not yet scheduled a date for Reyes’s sentencing.

Brocade judge denies Reyes new trial in blunt terms

Though U.S. District Judge Charles Breyer once seemed torn as to whether the government had proven its criminal options backdating case against Brocade’s (BRCD) former CEO Gregory Reyes, he has obviously gotten past those qualms now.

His order denying Reyes’s motion for a new trial, issued late Wednesday afternoon, was his bluntest articulation yet of the presumptively crooked nature of setting option grant dates through the use of “look-backs,” i.e., retrospectively choosing the date when the stock was at its low for the quarter.

“A juror in this case is confronted with a simple question,” he wrote. “Why backdate? . . . The most plausible answer is to hide expenses.”

He continued: “The only explanation . . . proferred by Reyes in this case — because Brocade wanted to obtain attract and retain talent . . . — is no true explanation at all. This explains why Brocade might have wanted to grant options with low strike prices, that is, at less than fair market value. But a company can give away options without backdating them. The chief purpose served by the act of backdating itself is to make the grants look as though they were granted at fair market value, and thereby to avoid a compensation charge.”

(In late July, when Reyes moved for an acquittal at the close of the prosecution’s case — claiming the case was too weak to even allow it to be submitted to a jury — Judge Breyer asked the government for special briefing and then deliberated for days before ultimately denying it.)

Reyes’s new trial motion had focused not only on the alleged weakness of the evidence against him, but also on alleged prosecutorial misconduct. Reyes’s counsel Richard Marmaro, of Skadden Arps Slate Meagher & Flom, argued that the government played fast and loose with the facts when it argued to the jury that Brocade finance and accounting officials had been deceived by Reyes. Marmaro argued that, according to FBI reports not shown to the jury, many finance and accounting people were in fact aware that look-backs were being used, at least on certain occasions. (Ten days after the jury convicted Reyes, the SEC charged Brocade’s former CFO Michael Byrd with civil fraud relating to options backdating at the company; another former CFO, Anthony Canova, had already been civilly charged prior to Reyes’s trial.)

But Judge Breyer accepted the prosecutors’ argument that their position, the SEC’s, and the evidence were all consistent: by falsifying corporate minutes Reyes could have intended to deceive accounting and finance officials, even if, over time, some of those officials eventually came to realize, or should have come to realize, what was going on.

Rather than punish the prosecutors by ordering a new trial, as Marmaro had asked, Judge Breyer criticized Marmaro, accusing him of not just pointing out gaps in the prosecution’s evidence to the jury — which is perfectly proper — but of “gap-filling,” which is not. “Defense counsel repeatedly represented to the jury what absent witnesses would have said if they had been called,” he wrote. Breyer said the uncalled witnesses — which included all of the company’s highest finance and accounting officials — could have been called by either side.

Finally, Breyer endorsed the prosecution’s ridiculing of an abortive defense strategy before the jury as “trying to carry out a lie,” a comment which Marmaro had challenged as prejudicial, unprofessional, and below-the-belt. Marmaro had originally had a defense expert, David Gulley, do randomness studies of Brocade’s grant dates, apparently with an eye to exploring the viability of suggesting that perhaps no look-backs had ever been used. Gulley’s calculations had showed that randomness was quite unlikely, however, and Reyes ultimately conceded that the grant dates were set through the use of look-backs.

The prosecutor had argued in summation: “Why on earth would you pay Dr. Gulley a lot of money to prove something that you now agree with the government, that there were look-backs? And the reason you do that is if you were trying to carry out a lie, to see if there was evidence to support the lie, including to pay Dr. Gulley to support it. That’s a lawyer’s argument we didn’t hear.”

Judge Breyer ruled that the argument was a “hard blow,” but not a “foul one,” citing the words that the Supreme Court has used in distinguishing between what prosecutors may and may not do. “Here, evidence . . . indicated that the defense had explored the possibility of presenting expert testimony in order to suggest a fact to the jury that it conceded at trial to be untrue. It was not unjustified for the prosecution to call that effort to the jury’s attention, whether to call into question the credibility of the expert witness, or more broadly, the credibility of the arguments presented by the defense.”

Why the judge ratified Reyes’s conviction

Shortly after the jury returned its verdict yesterday, convicting former Brocade (BRCD) CEO Greg Reyes of all ten felony counts charged in connection with options backdating at that company, Judge Charles Breyer made public his ruling confirming that there was sufficient evidence for the jury legally to have done so. The 11-page opinion, available here, seems to seal off a couple avenues of legal escape that those charged with backdating had hoped to invoke to avoid finding their fates in jurors’ hands.

Back on July 3, at the end of the prosecution’s case, Judge Breyer reserved decision on Reyes’s motion for a judicially-ordered acquittal, evidently assessing the evidence of Reyes’s criminal intent at the time as so thin as to border upon the legally insufficient. He took the motion under advisement while the defense presented its case and, then, continued doing so while the jury deliberated. He made up his mind on August 3, when he signed the order, though he did not file it publicly until after the jury spoke yesterday.

In the opinion, Breyer discusses both the issue of materiality (i.e., whether the non-cash expenses avoided through backdating were the sort of thing a reasonable investor even cared about) and the issue of criminal intent (did Reyes understand that backdating was wrong). On a motion like this, the judge is not supposed to decide how he himself would have voted had he been on the jury, but merely whether “a reasonable juror” could vote to convict, based on the evidence presented.

He seemed to find “materiality” the easier issue of the two questions to resolve. The prosecution didn’t have to prove, he said, that the additional non-cash expenses that were concealed through backdating would have changed an investor’s decision about whether to buy or sell the stock, but merely that a reasonable investor would have viewed that information as “as having significantly altered the ‘total mix’ of information made available.” He cited the testimony of a Fidelity analyst, who said that his firm looks unfavorably on any company that grants in-the-money options, since such options don’t motivate employees the way options are supposed to. A second analyst had also testified, in Breyer’s paraphrasing, said that “non-cash expenses, though perhaps not the most important metric of a company’s value or performance, were nonetheless pertinent to his investment decisions.”

Ultimately, Breyer’s verdict on materiality was a common sensical one: “If investors really did not care about the compensation expenses created by stock options,” he wrote, “the jury would be entitled to ask why the company went to the trouble of pricing them retrospectively, rather than just granting options in-the-money and accepting the accompanying accounting charge. If investors truly did not care about non-cash compensation expenses, then why bother to keep them off the books?”

When it came to the tougher question — whether a reasonable juror could find that Reyes’s criminal intent had been proven beyond a reasonable doubt — Breyer listed all the pieces of evidence weighing against Reyes, beginning with testimony that Reyes had baldly lied about the company’s retrospective pricing policy to the attorney conducting the company’s internal investigation in late 2004 and early 2005. Maybe the most stern and striking entry in Breyer’s list of evidence was his inclusion of the simple fact that Reyes had signed the firm’s financial statements, which somewhere included a line stating that the company had accounted for stock options in accordance with Accounting Principles Board Opinion 25, “whereby the difference between the exercise price and the fair market value at the date of grant is recognized as compensation expense.” Breyer’s unforgiving judgment: “Although a jury could view Reyes’ knowledge about the precise contents of these documents with skepticism, given his supervisory role as CEO, it would also be reasonable for a jury to infer from his approval of these documents that Reyes understood the accounting treatment of stock options described therein.”

While signing an inaccurate financial statement may not alone be sufficient to convict a CEO, it has consequences, and evidently helps take his case to the jury.

Reyes jury out, but overall message in

While the jury continues to deliberate over whether to convict former Brocade (BRCD) CEO Gregory Reyes of felony fraud in connection with that company’s options backdating practices, it is already clear that proving criminal wrongdoing in such cases is much harder than many experts originally predicted. It seems most unlikely that government will be attempting to prosecute many more pure backdating cases criminally in the future. (Cases of backdating plus self-dealing, forgery, and other shenanigans — like the alleged creation at Comverse Technology (CMVT) of a phony account in the name of “I.M. Fanton” (“I am Phantom”) — are another matter, of course.)

For the U.S. Attorney’s Office in San Francisco to come away with a conviction after this six-week trial — which involved a clear-cut, repeated, and long-term pattern of backdating plus evidence of after-the-fact lying by the CEO — it will have to win two arduous victories: one with the jury and, even if successful there, a second with the judge, who has already expressed concern about whether the government has proven Reyes’s criminal intent to even the bare minimum level legally required to sustain a jury verdict. Already one has to wonder whether prosecutors will proceed with their scheduled criminal trial of Reyes’s human resources subordinate, Stephanie Jensen, in light of how difficult it has proven to land the much bigger fish. (Though Jensen and Reyes were indicted together, Jensen’s lawyers won a severance, allowing her to be tried separately.)

Tellingly, on July 25, when the government charged KLA-Tencor’s (KLAC) former CEO Kenneth Schroeder in connection with that company’s options backdating, it brought only civil charges, even though the evidence of Schroeder’s guilty state of mind was arguably stronger than anything presented in the Reyes case. At KLA-Tencor the SEC alleges that in March 2001 the company’s general counsel e-mailed Schroeder a memo explaining why it was illegal to backdate, only to have Schroeder e-mail back: “Please don’t take away some of my best tools for attracting and retaining people. We need those people to win the battle. Help me, don’t just tell me how to follow a strict interpretation of rules. I need a ‘war time counselor,’ not someone who can recite page and verse.”

Nevertheless, even with this sort of powerful evidence about Schroeder’s state of mind, the SEC charges only that Schroeder “knew or was reckless in not knowing” (emphasis added) that his company was not properly accounting for the options it was granting — a mindset warranting only civil, not criminal penalties. (Schroeder’s counsel told the Wall Street Journal that, subsequent to this e-mail exchange, Schroeder spoke to the company’s finance chief and received assurances that the company was handling the options properly. See here.)

Even Apple’s (AAPL) former general counsel Nancy Heinen, whom the SEC charges with having ordered the creation of phony documents to conceal the backdating going on at that company, has only been charged civilly. And, of course, neither Apple nor its CEO were ever charged with anything.

Reyes may have been unfortunate in that Brocade happened to be the first company where backdating came to light. Its problems were not among those exposed by the famous Wall Street Journal Perfect Payday article of March 2006 (see here), but rather came to light more than a year earlier, when a disgruntled employee blew the whistle in late 2004.

On a tangential note, in their desperation to win their challenging case against Reyes, the prosecutors seem to have engaged in some unbecomingly fancy footwork, judging from both the motion to dismiss the indictment that Reyes’s counsel Richard Marmaro filed this past weekend and, to an even greater degree, the government’s legalistic response to it. It appears from the papers that the prosecutors bringing the criminal case have, at the very least, tried to present to the jury a much cleaner and more simplistic picture of what was happening at Brocade than was really the case. The prosecutors have argued to the jury, for instance, that officials in Brocade’s finance and accounting department “didn’t know a thing” of Reyes’s backdating and were deceived by him, but they’ve failed to call many of the key finance officials in question, several of whom have given statements to the FBI and SEC, according to Marmaro’s motion, suggesting considerable knowledge of and acquiescence in at least certain backdating transactions. Indeed, the SEC has charged Brocade’s former CFO Antonio Canova in a civil case, alleging that “he knew, or was reckless in not knowing,” that Brocade was backdating options and not accounting for them properly.

The government’s response to Marmaro’s motion fell far short of the outraged denial that one ordinarily expects in these Kabuki dances. Instead, it begins with the sort of fine, tortured, scholastic distinction that one doesn’t like to see used by public prosecutors: “The defendant [Reyes] contends that the allegations of the SEC’s complaint . . . are actually facts and that the United States’ attorneys erred by making arguments contradicted by those allegations qua ‘facts.’ . . . He cites no authority for that proposition.”

The hair-splitting then continues: “The United States Attorney’s Office . . . and the SEC are independent litigating entities. . . . Indeed, the SEC has on occasion taken positions in litigation opposed to that of the USAO.” Before it’s done, the government admits that it did, during rebuttal summation, “inadvertently” mischaracterize an exhibit related to this issue, but that the harm could be cured by having the jury instructed to disregard the prosecutor’s remark.

Brocade, Reyes, and Sonsini: Er, uh, never mind

Even before Brocade Communications System’s (BRCD) former CEO Gregory Reyes was indicted last summer for his role in that company’s stock options back-dating scandal, he seemed to be preparing to implicate Palo Alto superlawyer Larry Sonsini in the mess.

Sonsini’s firm, Wilson Sonsini Goodrich & Rosati, was Brocade’s outside counsel and Sonsini was a director on Brocade’s board. In an interview with Business Week in February 2006, available here, Reyes suggested that the company’s board was scapegoating him, and he seemed particularly incensed with Sonsini. Reyes argued that Sonsini — who had talked Reyes into resigning in January 2005, after an internal investigation at the firm confirmed backdating problems — had been the one who counseled him in 1999 to serve as a “committee of one” when granting stock options, rather than requiring the full board to approve each grant. This was a factor that had presumably made it easier for Reyes to backdate with impunity.

When I wrote a profile of Sonsini that ran in the November 17, 2006, issue of Fortune (available here), Reyes’s criminal defense attorney Richard Marmaro, of Skadden Arps Slate Meagher & Flom, also seemed to be linking Reyes’s plight to Sonsini, albeit more backhandedly: “Sonsini at all times acted totally above board and with the highest ethics of the profession,” Marmaro told me then, “and my client relied on his sage advice.”

But last Wednesday, the day Marmaro had told reporters he would be calling Sonsini as a witness , he didn’t, and it now appears likely that Sonsini won’t be called at all. (Marmaro did not respond to an email seeking comment.) The government had also put Sonsini on its witness list, but didn’t call him.

Reyes’s accusation against Sonsini — that he advised setting up the committee of one — was always a giant step removed from anything that would either truly exonerate Reyes of wrongdoing or truly implicate Sonsini in it. Notably, Reyes never accused Sonsini of telling him that it was okay to backdate, which is what the crime was. Committees of one were, and still are, commonly used for awarding options for lower level corporate executives, especially at companies like Silicon Valley startups for which options constitute a critical part of rank-and-file employees’ compensation. The law of Delaware, where Brocade was incorporated, authorizes their use for that purpose, and that’s the only use Brocade made of them. (Committees of one can’t be used for granting options to corporate officers, directors, or 10% shareholders — which would create a risk of self-dealing — and Brocade didn’t use them for that purpose.)

When I did my profile, Wilson Sonsini’s spokesperson also noted that, for what it was worth, the firm hadn’t even been the one that set up Brocade’s “committee of one” in any event. She said that committee had already been in place when Sonsini began advising Brocade, having been set up when a different law firm was advising Brocade, although she declined to name it. But in late May (as the Wall Street Journal reported here), after civil class action lawyers asked a judge to take judicial notice that Sonsini had set up Brocade’s committee of one (relying on press accounts of what Reyes told Business Week), the firm finally produced a copy of the February 1998 board minutes which do, indeed, show that the committee was created then, about 11 months before Sonsini began representing Brocade and joined its board. The firm’s outside attorneys in February 1998 had been Fenwick & West, another highly regarded Palo Alto firm, and the minutes were signed by its partner Dennis DeBroeck, as Brocade’s corporate secretary. (Wilson Sonsini’s filing, with the minutes attached as Exhibit A, is available here. DeBroeck, by the way — and I’m really just offering this in the spirit of “small world!” and not as an intimation of a vast conspiracy — is the husband of Nancy Heinen, the former general counsel of Apple (AAPL), who has been charged civilly by the SEC in connection with Apple’s backdating problems. (Calls and emails to DeBroeck and the firm’s chairman were returned by a spokesperson, who declined comment.)

Meanwhile, the pivotal issue in the Reyes trial has turned out to be what it so often is in white-collar trials: criminal intent. And though Marmaro has developed a rather complicated and interesting theory about why backdating involved no “material” misrepresentation (required to make out a fraud case), see earlier post on that, the crux of the case is proving to be much simpler and more basic: Did Reyes even realize he was doing anything wrong? In essence, it’s the Steve Jobs defense: Marmaro says Reyes didn’t understand the accounting repercussions of backdating. And just as the SEC evidently did not think it could prove Jobs knew that backdating was wrong (even by a less rigorous civil standard of proof), Judge Charles Breyer is now weighing seriously whether the government failed to meet its burden of proving beyond a reasonable doubt that Reyes knew he was doing something wrong. Breyer said he’d deliver his ruling on Thursday.

If Judge Breyer rules against Reyes and allows the trial to proceed, the moral for Reyes may be a hackneyed one: it’s not the crime, it’s the cover-up. The best evidence at the moment that Reyes knew he did anything wrong is that he allegedly lied to the attorney performing Brocade’s internal investigation in late 2004 when asked whether he used “look-backs” to price options at Brocade. The attorney, Craig Martin of Morrison & Foerster, testified that Reyes denied using look-backs — i.e., retrospectively looking for the lowest stock price of the previous quarter and then backdating options grants to that date — when in fact the company used them routinely and the evidence establishes that Reyes had to have known it did.

As bad as that looks, though, a crucial question remains as to when Reyes learned that there was something wrong with using look-backs. The backdating occurred from 2000 to 2002, so Reyes may have only learned that there was a problem much later. Much of the other evidence offered by the government as to Reyes’s state of mind suffers from the same problem. An email he authored, saying “IT IS ILLEGAL TO BACKDATE OPTIONS GRANTS,” was not written until October 2004. Similarly, a human resources officer who testified that Reyes told her, “It’s not illegal if you don’t get caught,” was uncertain as to precisely when the conversation occurred and even as to what Reyes meant by “it.”

The most likely outcome is that Judge Breyer will deny the motion for acquittal and let the jury grapple with the same questions itself. If he grants the acquittal motion now, the trial is over, the jury never gets to consider the case, and the acquittal order is unappealable, law professor Robert Weisberg of Stanford tells me, since double jeopardy attaches immediately. If, on the other hand, Breyer lets the jury decide the case, and the jury ultimately convicts, the judge could still enter a judgment of acquittal notwithstanding the verdict (called a judgment “NOV,” the acronym for the equivalent Latin phrase) at that point. In that event, the government could appeal the acquittal NOV and an appeals court, if it disagreed with Breyer, could reinstate the jury’s conviction.

On the theory that backdating’s not illegal if you account for it correctly

Whenever I write about backdating, many people write in to tell me that backdating’s not illegal; you just have to account for it correctly.

Since so many people think this is an important point, I thought I’d do a post addressing just that contention.

It’s not really true. What I assume people mean is that granting in-the-money options is not illegal, so long as you account for it properly. That’s true. But the whole point of backdating is to pretend that you’re not granting in-the-money options when in fact you are. And to say it’s up to the bean-counters to catch this situation is silly, because the whole reason you’re using phony dates is so that the bean-counters won’t know what you really did.

And this is why defenses to backdating sometimes get hard for me to understand. Sure the accounting rules are arcane and most people don’t know them. But if someone asks you to write down a date from a month ago on a legal document, rather than today’s date, doesn’t it give you pause? If someone presents you with a spreadsheet of the last month’s stock prices and asks you to pick the date on which you want to pretend that you granted, or were granted, several million options, might that not at least spur further inquiry?

When then-general counsel Nancy Heinen emailed Apple (AAPL) CEO Steve Jobs such a spreadsheet on January 30, 2001, she noted that it was a bad idea to choose January 2 as the grant date–even though that was the day the stock had been at its lowest–if they wanted “to avoid any perception that the Board was acting in appropriately [sic] for insiders prior to Macworld announcements.” (They ultimately chose one of the next-best dates from after Macworld.) Now isn’t it obvious to everyone on that email that shareholders are being misled? She’s saying that shareholders will naively think that the options were really granted on January 2, leaving them suspicious of springloading. It goes without saying that they also won’t realize that, in reality, it’s all being done a month later.

Now the fair response in Jobs’s defense at this juncture would be to say: “Well, look, people just didn’t look at this stuff the way they do today, post-Sarbanes-Oxley, and so on. This was spitting on the sidewalk back then.” And I can understand that argument. My question is, if that’s your position, how can anybody be feigning shock that Nancy Heinen then went on to file all the false documents that would be required in order to carry out what everyone understood to be a spitting-on-the-sidewalk type infraction they were willing to commit. At a public company, it’s not just foreseeable that any deception upon shareholders will eventually have to be reduced to writing–it’s inevitable.

Last October I interviewed Scott McNealy, CEO of Sun Microsystems (SUNW), for a different story, and I brought up the subject of options backdating. I thought his comment was telling: “When I sign a document and it has a date thing there? Usually I write down the date when I sign it. I didn’t even go to law school, and I figured out that that’s probably the most appropriate thing.”

By the way, even in the unlikely event that someone backdates options and accounts for them properly–i.e., treats them as in-the-money options–he would still almost always be violating the terms of the stock option plan which has been approved by shareholders. Those plans almost always require that the options be granted at fair market value on the date of the grant. And if there is a stock option plan that doesn’t contain that language, the backdater would still have to make disclosures in a half-dozen publicly filed documents about what he was doing. And what a weird disclosure it would be. Something like: “Please note that when we grant options, we sometimes pretend that we grant them on certain dates when in fact we grant them weeks later. Not to worry, though. We just do this to amuse ourselves, because we account for them properly using the real dates.”

Could the next person who writes in to remind me that backdating isn’t illegal do me a favor? Please name for me one company that has ever, in the history of corporate law, backdated stock options and yet properly disclosed and accounted for them.

SEC sees Apple backdating as one-woman fraud spree

Not far from the San Andreas Fault, a new fault line opened up in Silicon Valley yesterday — one that residents are actually thrilled to have discovered. We’ll call it the It’s All Nancy Heinen’s Fault. Heinen was Apple’s general counsel, and the SEC evidently believes she was the only one at Apple who engaged in any intentional wrongdoing in connection with that company’s repeated and blatant backdating. If only Heinen had also worked at Pixar.

In any event, we did get vivid new insight yesterday into exactly how the options backdating may have occurred at Apple (AAPL), as the SEC made public its civil complaint against Heinen and CFO Fred Anderson. (For the complaint, click here.) Anderson settled the less serious charges against himself and then filed an eye-opening press release of his own. Heinen, through her lawyer, still denies the complaint’s allegations and Anderson neither confirmed nor denied its accusations against him. (Anderson was only accused of failing to notice what Heinen was doing and failing to take affirmative steps to put things right.)

Apple, the company, is now home free, though the status of its CEO, Steve Jobs, remains slightly clouded. The SEC praised Apple for its “swift, extensive, and extraordinary cooperation,” citing in particular its “prompt self-reporting, an independent internal investigation, the sharing of the results of that investigation with the government, and the implementation of new controls designed to prevent the recurrence of fraudulent conduct.”

The cloud over Jobs stems from the written statement released by Anderson’s lawyer yesterday, which says that Anderson explained to Jobs the accounting implications of backdating in January 2001, at the time Jobs was backdating a 4.8 million-share grant to the company’s executive team, and 11 months before Jobs himself was granted 7.5 million backdated options.

The Executive Team grant, which was nominally dated January 17, 2001, worked like this, according to the SEC complaint. On January 30 Heinen emailed CEO Jobs and CFO Anderson spreadsheets laying out Apple’s stock prices for every day in the month of January, and recommending possible dates on which to retroactively date the grant. In her email to Jobs she wrote, “To avoid any perception that the Board was acting in appropriately [sic] for insiders prior to Macworld announcements, I suggest we use Jan. 10, the day after your Macworld keynote, at $16.563. That was one of the lowest closes of the month, after the $14.875 price on Jan 2. I don’t think the [Executive Team] would object to the $1.688 difference to avoid claims of inappropriate conduct.”

The email seems grimly ironic, since she evidently fears leaving the misguided appearance that they were springloading — granting options just before favorable news — when in fact they were backdating, which is even more underhanded. (How Jobs processed all this, I leave to you.)

Ultimately they settle on January 17 (stock price $17.813), and the paperwork — unanimous written consent forms, or UWCs—are drawn up falsely reflecting that board action was taken on January 17. Heinen finally collects all the signed UWCs on February 7, when the stock price is $20.75.

It’s not explained what each board member was thinking when he signed the UWCs in early February, but I suppose some may have really believed that the grant decision had been made on January 17 (though it was supposed to be the board’s decision to make, since there was no compensation committee at the time), while others didn’t examine the UWCs closely, and still others didn’t know what difference any of it would make. Still, one of the board members was Jerome York—a former CFO of IBM and Chrysler—a point former CFO Anderson emphasized in his lawyer’s statement yesterday. (York was also later named to the three-person special committee that conducted Apple’s internal investigation of the backdating. He has previously said that he recused himself from looking at decisions he was personally involved in. The others on the committee were former vice president Al Gore, who headed it, and Google (GOOG) CEO Eric Schmidt. Schmidt was formerly CEO of Novell, which has not yet completed its own internal inquiry into backdating that occurred there during Schmidt’s tenure.)

The conversation Anderson says he had with Jobs — in which he explained the accounting ramifications of choosing any date prior to when the board had actually given its approval — would have had to occur early in the process of awarding the grant, at a time when Jobs was planning to use the Jan. 2 date for the grant (the date Heinen thought would look too much like springloading). Anderson’s attorney says that Anderson “was told by Mr. Jobs that the Board had given its prior approval and the Board would verify it.” When asked about this account by the Wall Street Journal yesterday, Jobs referred the question to an Apple spokesperson, who declined comment.

Later that year, in August, the board decided to award Jobs a huge options grant, because a previously awarded 10-million share grant was now under water. By that time, Apple had set up a compensation committee, which consisted of York, Genentech (DNA) CEO Arthur Levinson, who chaired it, and Intuit (INTU) chairman William Campbell.

On August 29 the board decided (really, really decided) to issue Jobs’s options as of that date, when the price was 17.83. But subsequently Jobs became unhappy with the vesting schedule, and he and the compensation committee began haggling over that. (Technically, matters like vesting schedules are supposed to be settled already by the time the strike date is set, so this created an awkward situation.) The haggling went on for months, with the compensation committee holding meetings on October 16 and 19, and again on November 19 and 20. (Heinen, as corporate secretary, attended these meetings.) By mid-December, the complaint says, Heinen decided that the August 29 date would “no longer withstand scrutiny,” since, among other things, Apple’s fiscal year ended in late September, the relevant information had still not been supplied to auditors at KPMG, and the SEC filing deadline for reporting an August 29 grant had passed. So on December 17 she emailed the chair of the compensation committee, Levinson, with a spreadsheet of three months worth of stock prices and some recommended dates for backdating the grant. “There are several days in October and November, following the first meeting of the Compensation Committee . . . that are close to the Aug. 29th close of $17.83,” she wrote. “I suggest using a day that the Compensation Committee held a telephone call, either jointly or individually with the members.” I assume the SEC includes that detail because it believes Heinen made that suggestion so that the company could plausibly pretend that a board decision had already been reached on one of those dates.

On December 18, when Apple’s price was $21.01, the compensation committee and Jobs finally came to agreement on the vesting schedule, and the next day Levinson emailed the full board, cc-ing Heinen, explaining that the grant date would be October 19, when the price had been $18.30. (That corresponded to the date of one of the compensation committee calls.) Levinson wrote, “For the record, I informed Nancy [Heinen] in advance of our intentions and of the above specifics to be certain we were conforming to all legal requirements/guidelines.” This assurance, presumably, was sufficient to satisfy that SEC that all the other directors did not realize that anything improper was happening. (Levinson referred a request for comment to an Apple spokesman, who referred me to the SEC’s exoneration of Apple as a company, and its glowing endorsement of Apple’s cooperation in the its inquiry.)

In January 2002, Heinen allegedly had phony board minutes drawn up to reflect a “special meeting” on October 19, and saw to it that the August 29 board minutes (which had already been approved by the full board in November) were altered, with similar changes being made to the compensation committee minutes. (None of these alterations were cleared with the board, the SEC says.) Then she allegedly signed the phony minutes and an accompanying Corporate Secretary’s certificate, affixing the latter with the corporate seal and falsely attesting that the date was then November 2, 2001.

What do people think? Everyone happy with the It’s All Heinen’s Fault theory? Honestly, I don’t know anymore.

On Friday, in a terse, one-paragraph statement that was even more opaque than the very similar one Apple (AAPL) issued in December, the audit committee at Walt Disney Co. (DIS) cleared Steve Jobs of any “intentional or deliberate acts of misconduct” in connection with the options backdating that concededly occurred at Pixar (PIXR). Disney, which acquired Pixar in 2006, shed no light on how the backdating came to pass, but cleared anyone “currently associated with Disney” of wrongdoing.

The backdating at Pixar was in some respects even more extreme than at Apple: top officers were repeatedly granted options on dates when Pixar stock was at its lowest point for the year. On the other hand, unlike the situation at Apple, none of the Pixar options went to Jobs himself. At Apple, the special committee also acknowledged that Jobs may have actually been involved in “recommending” dates for options grants — a circumstance that, on its face, suggests involvement in either backdating or springloading. (The latter term refers to the suspect practice of executives granting options to themselves or others just before new market events are about to give the stock price a big boost, as the executives know due to inside information.)

The story line at both Apple and Pixar appears to be that Jobs, the notorious micromanager who headed both companies at the time of the backdating, did not understand the legal or accounting ramifications of backdating. Interestingly enough, virtually Jobs’s only compensation at either company during this period was coming from the Apple options whose workings he so poorly understood. (During the relevant years, his salary at Apple was famously just $1 per year, while at Pixar it was about $55 per year.)

The thing that puzzles me most is this: If you don’t understand the accounting ramifications of backdating, why do it? Why not just issue the options dated as of the actual date you’re issuing them, and simply choose whatever strike price you think is appropriate — even though it may not correspond to the current stock price?

Take, for example, the situation at Apple, for instance, where Jobs received a grant of 7.5 million options options that wasn’t finalized until December 19, 2001, when the stock price was $21.01. The special committee found that these options were backdated to October 19, 2001, when the price had been $18.30. (Phony documents were created to reflect a board meeting on October 19 which never really occurred.) Well, if you don’t understand the accounting implications of backdating, why not just issue the options as of December 19, but announce a strike price of $18.30?

The answer, of course, is that someone at the company certainly did understand that if you did that, you’d be granting “in-the-money” options, which have onerous accounting and income tax repercussions for the company. The whole point of backdating is to avoid those consequences. To do that, you pretend that the options aren’t in-the-money, even though they really are. So why go through that deception if you don’t understand the accounting implications of granting in-the-money options?

And if Jobs himself didn’t understand the accounting implications that were driving the deception that he himself (at Apple, at least) was benefiting from and, to the extent he was “recommending” grant dates, participating in, why didn’t the underlings who did understand ever try to explain to Jobs the perilous legal situation he was getting himself into? Were they too petrified to tell him something they assumed he didn’t want to hear, or already knew, or both? What a guy to work for.

Can readers explain to me why a company’s executives would engage in backdating when they didn’t understand its accounting implications?